Vexing Convexity

Back in the day, we used to love watching the convexity crowd come stampeding in (or panicking out) to the color coded back months of the Eurodollar pit. The action was usually big and powerful with just a hint of fear. Reports, completely fraudulent, from Fan and Fred about "duration gap" would add to the fun. One characteristic was always there, the duration/convexity guys were most active near the end of the party. Countrywide was a huge participant led by their George Hamilton-like CEO.

Today, the Fed is Twisting and Refis are robust. 81% of all mortgages written are refinances and this week's applications moved up again. That "giant sucking sound" is convexity and 10 year equivalents are being extinguished even though rates have seemed to be low for some time. More LSAP QE could be on tap in the mortgage bucket even as maturing assets are rolled into Treasury paper.

The Fed has publicly moved to an inflation guideline with the 5 year B/E below 200 and price deflator hovering around 1.5% for close to 4 years. As another LTRO approaches, not nearly enough criticism has been hurled at the misguided policies of the Trichet led ECB. Outside shocks were hitting the fragile US recovery, Asia was weak and the ECB was sterilizing, keeping their currency up and even raising official rates. Money metrics were collapsing. The peripheral bond rout followed - with lag - right on cue.

We believe the Fed should restrain from further duration/convexity crowding with the ECB now getting religion. At the peak of the party, Countrywide leased the offices next to ours. All new Herman Miller work stations and glass offices were built out over looking Chicago's River North. Many corner units for MDs had showers. Then the music stopped. Not a single worker ever plugged in. A BofA executive toured it and locked the door. I'm fearful Ben is close to shaving the beard and working on his tan.